Don’t Let the Major Market Indexes Hurt Your Trading

A large proportion of the discussion in the financial media is focused on the Dow Jones Industrial Average, S&P 500, and Nasdaq. These indices are media shorthand for THE stock market. If the S&P 500 is up today, then the market is good, and if it drops, then it was a bad day.

This is a convenient way to talk about the market in general, and there is some correlation between what the indexes are doing and the movement in the majority of stocks. Indeed, if we didn’t have indexes, then the folks that write headlines about the stock market would have a much tougher job because there needs to be some form of generalization to convey what is going on.

Unfortunately, these generalizations are often wildly misleading.

The problem for traders and investors is that indexes often cover up the opportunities or problems that exist in individual stocks. The indexes have been particularly misleading in 2021. They have consistently hidden very broad weakness in growth names, small-caps, and speculative stocks. They have also sent a misleading message about the overall technical health of the majority of stocks.

Based on the indexes, it is easy to conclude that most of the market is wildly extended and must be very expensive. The reality, though, is that around 55% of all stocks aren’t even trading above their 200-day simple moving average of price.

There are two basic types of markets: those that are driven by the indexes and those that are driven by stock picking. Index-driven markets are usually caused by macro news flow. We had a good example on Monday as concerns about the Evergrande situation in China caused very broad selling. The merits of individual stocks didn’t matter much, as everything was dumped in tandem due to the big-picture concerns.

Typically, downside action tends to be more index-driven than upside action. When all stocks are sold together due to macro worries, this almost always leads to stock-picking driven markets. Once the index-driven selling is over, traders and investors sort through the wreckage and start identifying those stocks that have been unfairly sold. The best bargains are created when there is panic in the indexes and stocks are sold due to fear and disgust.

It can be very helpful to determine whether the market action is index-driven or stock picking-driven, but you will rarely see that distinction made in the business media. The indexes are always viewed in the exact same way, even though their influence on the overall market can vary tremendously.

I often find it helpful to view the indexes as a separate asset class. They obviously can be and are traded in a vacuum without regard to what the majority of stocks may be doing. Timing indexes is extremely difficult and the vast majority of traders err on the side of being too early when they try to call market turns. I’ve written quite frequently about how it is better to be reactive rather than anticipatory when it comes to timing, but I often find it…